Do CEOs Really Have the Power to Raise Wages?

“We explain how a wage rate is determined in much the same way we’d explain how the price of soybeans is determined. We do this for one simple reason: It works.”

Except it doesn’t always work. Supply and demand can’t explain why Dan Price, the founder of a small credit card processing firm, would raise the minimum salary at his company to $70,000. Price is “cutting his own salary from nearly $1 million to $70,000 and using 75 to 80 percent of the company’s anticipated $2.2 million in profit this year” to pay his employees. It’s hard to imagine the same thing happening in the market for soybeans.

Price’s story is extreme, but his divergence from textbook economics is more than a theoretical curiosity. American companies are flush with cash, while wages remain stagnant. Plenty of policy changes have been proposed to address this imbalance, but what, if anything, can companies do on their own to put a dent in income inequality? Specifically, what would happen if more CEOs took a page, or even a paragraph, from Price’s book and raised their employees’ salaries? The conventional wisdom here is shifting quickly, with implications for how companies should compensate their workers.

When McDonalds’ CEO announced last month that he was raising 90,000 employees’ wages, he claimed he was “taking action to make McDonald’s a modern, progressive burger company.” When Walmart announced something similar in February, its CEO positioned the move as a show of solidarity: “After all,” he wrote, “we’re all associates.”

Pundits weren’t buying it. Severalsuggested that the real reason for the wage hikes was an improving economy. More jobs and fewer unemployed workers should translate into higher wages, just like with soybeans.

Supply and demand often do a decent job of explaining how workers are compensated. To this way of thinking, no single firm sets wages; the price of labor is set in a competitive market. If that’s true, firms can’t raise wages much above market rates without hurting their competitiveness. As my former colleague Justin Fox writes, “By the mid-1990s the idea that companies had to keep wages low to be competitive globally, and that this thing called ‘the market’ simply could not be defied, was pretty widespread.”

But in recent years, a growing chorus of commentators have rejected this reasoning, citing research suggesting that the market for labor isn’t like the markets for everything else. “Wages are not, in fact, like the price of butter,” Paul Krugman wrote in March, “and how much workers are paid depends as much on social forces and political power as it does on simple supply and demand.” Furthermore, he argued, “Paying workers better will lead to reduced turnover, better morale and higher productivity.” For companies, that last bit is particularly worth paying attention to.

In 1914, Henry Ford famously announced that his company was doubling wages for most of its male factory workers, raising them to $5 a day. He didn’t need to attract more workers — candidates would line up around the block to apply — and by all accounts he already paid competitive wages. He did have a problem with absenteeism.

Larry Summers and Daniel Raff of Harvard examined Ford’s decision in a 1987 paper, and found that the move reduced turnover, boosted productivity and profits, and attracted even more candidates to apply. They present Ford’s experiment as a case study in the benefits of what economists call “efficiency wages” — paying workers more than a company might be able to get away with.

The theory of efficiency wages has made a comeback in recent years. It suggests that firms sometimes have an incentive to pay workers more than the going rate because doing so attracts better candidates, motivates them to work harder, and encourages them to stay at the company longer. Since shirking and turnover are costly, higher wages make financial sense, at least up to a point.

But the story of efficiency wages doesn’t start and stop with traditional economic incentives. The justification for higher wages also hinges on psychology and the “social forces” that Krugman alludes to. For instance, workers have strong views about how much profit is fair for their company to make, and when they’re paid less than they think is fair they don’t work as hard. These views aren’t set by supply and demand, but depend on social context. That’s why lower paid workers tend to make significantly more in industries where other positions are well paid. Administrative assistants who work alongside highly compensated engineers make more than their counterparts in other fields, because the norm of fairness partially trumps market forces.

“Social custom” also shapes what managers think is fair, according to Jonathan Schlefer, a researcher at Harvard Business School who has written extensively about the shortcomings of modern economics. “If you actually look what CEOs were saying in the ‘50s and ‘60s they were saying that good wages are an important part of the American way of doing things,” says Schlefer. “Things that you couldn’t imagine the U.S. Chamber of Commerce saying today. It’s not as if businesses in the 50s and 60s didn’t care about making money because they clearly did. They just saw it in different terms.”

Not everyone agrees that paying workers more will benefit firms, and even advocates of efficiency wages note that there are limits. “I think that we have a chunk of evidence that efficiency wages can work as one (possibly underutilized) approach,” says Jan Zilinsky, a research analyst at the Peterson Institute for International Economics, which recently published a white paper explaining the benefits of higher wages. “But it is not a universal theory that necessarily applies to every worker.”

“It depends on the work that they’re doing,” says Barry Hirsch, a labor economist at Georgia State University. “If it’s the type of workforce where you can’t measure what they do very well, and it involves a lot of goodwill on their part, then taking a high-wage strategy might work.”

This point was echoed by Zeynep Ton, a professor at MIT Sloan School of Management and author of The Good Jobs Strategy, who emphasized that high-wage strategies require firms to actively change the way they design work for their employees. “What I found in my research is companies in the retail sector that paid people more also asked them to do different things,” Ton says. “For example, [at the convenience store chain QuickTrip] people don’t just sell merchandise, they also order merchandise. They can contribute more to the company.”

Adam Ozimek, an economist at Moody’s Analytics, is more skeptical. He finds it plausible that workers who are paid above the market rate work harder, but questions why, if that’s true, firms haven’t figured it out by now. “Where’s the hedge fund or private equity firm that has formed on the basis of buying companies and raising wages for increased profit?” he asks. In fact, some of the work on efficiency wages assumes companies are already paying them, which would mean they can’t pay more without facing competitive pressure.

Still, some experts believe there are plausible reasons why companies would fail to recognize the benefits of paying workers more.

Former labor secretary and Berkeley professor Robert Reich points to firms’ obsession with short-term performance. “Companies haven’t figured it out because they’re focused on quarterly earnings, not long-term productivity gains,” he says. (Ton also made this point.) “Furthermore, Wall Street looks at payroll costs, not at productivity gains. Even if they’re a private company, productivity gains are more difficult to measure than costs.” (I interviewed Reich earlier this year about Obamacare, full-time work, and the labor market.)

Managers may also be too risk-averse to recognize the benefits of higher pay. “The manager can easily rationalize staying the course, or simply doing roughly what the competition is doing,” says Zilinsky. “Bold moves, like company-wide raises, are not guaranteed to work precisely as desired. So the risk of having to explain suboptimal outcomes after a policy change is not an appealing prospect.” (Price has been praised, but also widely criticized for his decision.) Zilinsky also notes that some CEOs may fear that such a move would give the impression of “giving in to labor.”

Price told The New York Times that “there is nothing in the market that is making me do it,” meaning he isn’t raising wages just to boost profits. Traditional economic theory would predict that he’ll pay for it, as less generous firms are able to reinvest more of their profits back into their businesses. But there’s no guarantee that that’s right. There really are many ways in which labor and soybeans are different, and in some cases that means that paying workers more will pay for itself through increased productivity.

Much of the psychological research on wages focuses on the idea of a “gift exchange” between employer and employee. When a firm offers the gift of generous wages, employees reciprocate with the gift of harder work. Price, perhaps like Ford before him, is certainly giving his employees a gift. We’ll see what he gets in return.